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Gloomy Western bears are wrong about China's banks

Beijing’s new banking regulator faces pressing issues, but no dramatic shakeup is needed

| China

For years, mainstream foreign media and investment analysis has revolved around a largely gloomy narrative that describes Chinese banks as rickety, and awash with bad debt. In this narrative, it is just a matter of time before a banking crisis jolts the Chinese economy off course.

The failure of these dire forecasts to materialize has not deterred the skeptics. Each year they identify new problems that they predict will bring down the banking system. But does Guo Shuqing, recently appointed the third chairman of the China Banking Regulatory Commission, really face a potential banking crisis? And what reforms of the banking system are really needed?

From 2003 to 2016, I served successively on the boards of two Chinese banks as an independent director. I was privileged to observe and take part in the "night and day" transformation that took place in China's 17 large nationwide commercial banks over that 13 year period.

After the banking debacle of the 1990s, the Chinese government realized that a strong and competently managed banking system was essential for funding the nation's growth. It moved decisively to clean up the banks, starting with the five largest, followed by the medium-sized joint stock banks.

Bad loans were stripped out, banks were listed and recapitalized, management and operations were professionalized. Excess staff were shed, top caliber people were put into senior and middle management. Boards and CEOs were mandated to control risk -- never again should the Chinese government use tax money to bail out banks. Banks aggressively revamped their operations, importing global best practice in all areas.

This banking transformation occurred at a time when China's economy was growing at double-digit annual rates, mostly funded by commercial banks. Bank balance sheets expanded rapidly and profitability grew, allowing banks to fortify capital positions, set aside significant provisions against the inevitable eventual slowdown in economic growth and pay dividends to shareholders.

As transformation of the commercial banks got underway, the banking regulatory authority was split from the central bank as a separate entity in 2003. Under its first chairman, Liu Mingkang, the CBRC rapidly built up competence as an effective supervisor of the banking system. The CBRC was proactive, not limiting itself to the classic regulator's role of preventing banks from getting into trouble. It also guided banks in their transformation, prodding them to upgrade the quality of corporate governance, risk management, and internal controls.

Given the steady transformation of the major banks and the strength of the banking regulatory authority, what will be the reform focus of the CBRC under Guo's leadership? Looking at pronouncements on the reform of the financial system under Chinese President Xi Jinping, there is a conspicuous absence of any mention of a need for banking reform.

Why is that so? The answer lies with China's larger banks, which account for most banking assets and are in reasonably good shape. Transformational reform has been completed. What is needed are measures to assist banks in coping with bad loans resulting from the decelerating economy, from problems in the state-owned enterprises  sector, and from increased exposure to the private sector, especially small and medium sized companies.

Coping with delinquent borrowers is not a transformational reform -- it is the normal activity of banks when economies are slowing. It is also the price to be paid for the large amount of credit extended in the stimulus program of 2008 and thereafter -- a stimulus that paid off in continued growth, maintenance of high employment, and construction of much needed infrastructure. Some of that credit did not go to viable projects or healthy SOEs, and banks now must deal with that problem.

Overall levels of debt relative to gross domestic product have risen rapidly over recent years. Corporate SOE debt is of greatest concern. In a socialist market economy guided from the top, banks support national plans. State-owned banks made loans to state-owned companies -- in effect moving money around the national balance sheet -- with the implicit understanding that the state would ensure the loans would be serviced. This appeared to be sovereign exposure, a prudent risk for the banks.

Solving the SOE "problem"

The solution of the SOE debt problem can take two forms. First, "financial engineering" -- stripping bad loans out of SOEs and into asset management companies, and debt-equity swaps. Debt-equity swaps will be used for potentially viable SOEs that can be turned around. These swaps reduce the SOE debt burden, and lower the overall ratio of corporate debt to GDP. But until an SOE is reformed, all that has happened on the books of the lending bank is that a non-earning loan has become a non-earning investment -- the total of nonperforming loans is reduced, but the bank's revenue is not improved, and the potential loss remains. This only buys time.

The real solution of banks' SOE debt problems lies largely outside of the banks' control. Under national reform plans set out in 2013, improving SOE efficiency is a priority. Carrying out this reform will be a massive challenge. Resistance from vested interests and inbred bureaucratic cultures will be formidable. The success or failure of the government's efforts in SOE reform will determine whether debt for equity swaps result in dividends and capital gains for banks, or simply put off the day of reckoning when the asset must be written off.

Despite the obstacles to SOE reform, there is no need for undue pessimism. It was only a decade ago that the state-owned banks were transformed from moribund relics of the planned economy into profitable organizations. Given adequate political will, there is no reason why other SOE sectors could not be similarly turned around.

One path the government could take would be "financialization" of SOE ownership -- along the lines of the financial holding company Central Huijin's ownership of key banks, and akin to the Temasek model of government ownership of corporations in Singapore. If that path is taken, banks acquiring seats on SOE boards of directors could become agents of change as they pressure SOEs to improve efficiency.

Guo, as CBRC chairman, can only facilitate the financial engineering of SOE debts. SOE reform itself is the responsibility of top national leadership. He must, however, address  some other pressing issues.

First, the transformation of banks must be driven down from the top tier national banks to the thousands of local banks, which exist in a variety of forms. Some are doing well, but others have major governance and asset quality problems that need to be addressed.

Second, the shadow banking sector has grown rapidly, largely unsupervised. The risks of shadow banking are often exaggerated by observers, but nonetheless, to prevent destabilization of the financial system, possibly with knock-on effects, shadow banking must gradually come under better control.

Third, Chinese banks now lend large amounts to SMEs, but do not yet have the necessary experience and skills to analyze private sector risk properly. This is a much under-recognized long-term weakness. The capabilities of banks in lending to private sector firms, especially SMEs must be upgraded, otherwise we can expect serious NPL problems to arise out of private sector lending.

Fourth, the emergence of China as a world leader in the development of financial technology presents great opportunities, but also risks. Unlike the other challenges already mentioned, China is at the forefront in fintech; there are no models in other countries for it to follow. Fintech lying outside the existing supervision of any of the regulators must be guided so that Chinese companies and individuals realize the benefits, while preventing abuses. How China handles this will be fascinating to watch, and may provide models for the rest of the world.

As the CBRC undertakes these tasks, bear in mind that China's banking authority is not independent. Major initiatives by the CBRC must be supported and coordinated by the Politburo of the Chinese Communist Party and the State Council, China's cabinet, which will consider the timing, costs, and benefits of proposed policies and how they impact other national interests.

China is committed to the reform of SOEs and to strengthening the banking sector. But in its usual style, it will be pragmatic, set priorities, proceed cautiously to minimize unanticipated consequences, and roll out reforms at a pace that will not cause disruption.

Reform Chinese-style does not proceed by dramatic "big bangs." It progresses slowly but surely, step by step.

James Stent is the author of "China's Banking Transformation: The Untold Story" (Oxford University Press 2017)

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